Low volatility: Calm before the market storm?

Investors are split on how long the current period of low volatility can last, with some experts warning of a potential crash as monetary policy returns to normal in the UK and US.

The most well-known measure of volatility is the Vix – used on the S&P 500 – which is hovering around a multi-year low. This low volatility has become a phenomenon, according to research firm Capital Economics, with signs of a decline in volatility also witnessed across currency markets and commodities such as crude oil.

So what is it about the current climate holding markets on such a steady course? Capital Economics chief global economist Julian Jessop attributes it to investors’ confidence in monetary policy and the broader economic outlook.

“The low levels of volatility in financial markets reflect a high degree of confidence in the ability of the authorities to prevent crises and respond to shocks, expectations that any policy changes will be gradual and a reduction in economic instability,” he says.

But “none of these factors can be taken for granted”, he adds, because prolonged periods of low volatility “can themselves increase the chance of a crash”.

Industry experts have raised concerns that low volatility could be about to come to a halt. Bestinvest managing director Jason Hollands echoes Jessop’s warning that investors have become complacent about the support of monetary policy.

“After years of highly accommodative monetary policies, many investors have taken the support provided by central banks for granted and there is an assumption by some that the good times will continue to roll,” he says.

There are also reports the Federal reserve itself is becoming concerned about complacency in financial markets, according to Hollands.

This year has seen the rise of a number of geopolitical risks which have the potential to trigger “market jitters”, says Hollands, but appear to have done little to dissuade markets from steadily grinding higher.

But despite the appearance of market confidence, Hollands urges caution. He says: “While none of us has a crystal ball to predict the short-term pattern of markets, gut instinct tells me that when markets are high, compelling valuations are absent across most asset classes and retail fund flows have soared, it is time to be a little more cautious.”

The latest Barclays Wealth market report also argues the lack of volatility has become a worry for investors.

“The serene progress of equity markets so far this year continues to worry those trying to call the short term. The absence of things to really worry about is, in itself, worrying,” it says.

Barclays expects volatility “to rise from here” as monetary policy begins to normalise in the US and UK, bringing with it “more testing times for investors”.

But other experts believe this backdrop of low volatility and near-market highs could be here to stay – at least in the short term.

Henderson Global InvestorsGlobal Trust manager Wouter Volckaert acknowledges concerns over a potential correction are an ongoing issue for markets. “In this market rally, even though there are reasons for the equity market to be strong and this strength could continue for a couple of years, it could also end within two quarters and it is very difficult for a lot of people to live with that uncertainty,” he says.

He points to risks from the lack of earnings growth in markets and the more general concern that some of the problems which led to the massive market correction in 2008 have not been fully addressed.

He adds: “People are a bit afraid that any day something could blow and we could go into the next recession – and this could be true.”

But Volckaert says markets could continue to move higher as a result of ongoing economic improvements and the continued accommodative stance of central bankers. “You cannot predict this market peak by looking at market levels. You need to focus on behavioural science and how the market behaves as a group,” he says. “A lot of the multiple expansion has been driven by a strong belief in quantitative easing but if a more high-profile figure, say Angela Merkel, starts doubting QE, the market may become more cautious. But as long as that psychological change does not happen, we may just continue to grind higher.”

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14th August 20182:45 pm

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